WASHINGTON -- Beginning on Jan. 1, people who lose their home to foreclosure will be required to pay federal taxes on any unpaid mortgage the bank can't recoup through an auction. The same will be true for homeowners whose loan principal is reduced by a mortgage modification, with the wiped-out loan being treated as taxable income.

The new tax obligation will hit because the Mortgage Forgiveness Debt Relief Act expires at the end of the year. The 2007 law was passed to save struggling homeowners from getting whacked twice, first by the sagging housing market and second by the Internal Revenue Service. Its expiration could push more people to remain in homes worth less than their mortgages, slowing the housing market's recovery.

"The housing market is in its first stages of recovery, making now the worst time to take this exemption away from homeowners," Rep. Jim McDermott (D-Wash.) told HuffPost. McDermott has introduced one of the bills geared toward extending the exemption.

"This exemption allows homeowners to write down their mortgages and refinance without incurring a hefty tax bill," he added. "This ultimately lowers monthly mortgage payments, leaving more money in the hands of homeowners at a time when they need it most. If Congress does not act, the gains the housing market has made will be wiped away."

The Washington Post reported on Friday that a number of former White House economic advisers and other economists consider the sagging housing market to be one of the greatest obstacles to recovery. Yet Treasury Secretary Timothy Geithner and others in the administration think there is little more they can do to help struggling homeowners, according to the Post.

Extending the tax exemption would help. The exemption, which can be as much as $2 million per household, covers individuals who negotiate a principal reduction on their existing mortgage, sell their house short (i.e., for less than the outstanding loans), or participate in a foreclosure process.

Under normal circumstances, homeowners who sold their house for less than the balance of the mortgage -- and were forgiven the difference by the bank -- would have to pay income tax on that windfall. Negotiating a reduction in the mortgage principal would also generate tax liability.

For example, an individual who owed a $400,000 mortgage might decide to sell the house, now worth $300,000 on the local market. If he sold the property short and the bank forgave the extra $100,000 -- an arrangement that benefits the lender because it recoups more of the original loan than would a foreclosure -- the IRS would consider that amount as income, on which the borrower could owe thousands of dollars in taxes.

"This has the effect of pulling people up with one hand, and hitting them in the face and knocking them over the cliff with the other," Sen. Jeff Merkley (D-Ore.) told reporter David Dayen back in August.

An extension of the tax exemption would appear to be a common-sense means to help stabilize the housing market, but the political turmoil around the fiscal-cliff negotiations means common sense may not win out.

"The challenge is that a single-issue tax provision of this type -- of any type, frankly -- just simply doesn't move on its own," said Linda Goold, tax counsel for the National Association of Realtors. "It will be part of a package or it will not move. ... It is really tied to the future of what happens with the big deal and then whatever they come up with after that relating to the provisions that either have or will be expiring."

House Minority Leader Nancy Pelosi (D-Calif.) believes that the mortgage relief provision will be on the table during the grand-bargain talks, according to communications director Nadeam Elshami.

"Extension of this tax provision has passed by a bipartisan vote in the Senate Finance Committee, and we anticipate that it will be part of Congress' year-end negotiations," Elshami said. "Democrats hope to work with the House Republican leadership to support bipartisan measures which benefit the middle-class homeowners."

A senior House Republican aide said the provision would likely be dealt with as part of negotiations around a variety of tax exemptions set to expire at year's end. Those negotiations, he said, wouldn't begin in earnest as long as the fiscal-cliff talks were under way.

A spokesman for Senate Majority Leader Harry Reid (D-Nev.) said that Republicans declined to move the extension bill forward in the Senate Finance Committee. "Senator Reid tried to move the bill before we left, but was unable to get the Republicans to agree, even though it received strong bipartisan support from the committee," said Adam Jentleson.

"If you can't make your monthly mortgage payment, how on earth are you going to come up with $50,000 or so in taxes?" asked Rep. Brad Miller (D-N.C.), who led the push for the Mortgage Forgiveness Debt Relief Act when it first cleared Congress in 2007. "Principal reduction is by far the most successful kind of mortgage modification. If we can't extend the exemption, principal reduction is dead. Any bargain that doesn't extend the exemption won't be grand for the housing crisis."

Thousands of homeowners have taken advantage of the exemption over the past five years, but many more still need help.

"About 22 percent of the residential mortgages are underwater. That’s over 11 million households that would be hit with an additional tax if they were lucky enough to get a short sale or mortgage modification from their bank," McDermott said. "More importantly, the national foreclosure settlement requires a significant amount of mortgage modifications, which, if Congress does not extend this exemption, will be made useless."

According to CNN, more than 50,000 homeowners are foreclosed on each month, and around 500,000 have participated in short sales during the last six months alone. Under the National Mortgage Settlement reached last February between the federal government and five of the nation's top lenders, another 1 million homeowners could see their mortgage principal reduced.

Rep. Charles Rangel (D-N.Y.), who sponsored the 2007 law, is working with the House Ways and Means Committee to ensure that the exemption is on a list of tax extensions on which Congress is likely to vote this year, according to his office.

But Miller is less optimistic that Congress will make headway before Jan. 1, given that Republicans consider the measure to be a Democratic win. "Extending the exemption two years ago went down on the ledger as a give to Democrats," Miller said. "The only way it gets extended again is if the Obama administration insists that it has to be part of any deal."

Like McDermott, Rangel has introduced a bill on the House side, and Sen. Debbie Stabenow (D-Mich.) is championing a similar measure on the Senate side. Only Stabenow's bill has bipartisan sponsorship, and all three bills are stagnating in committee.

Even if Congress cannot extend the mortgage relief exemption this year, many note that a deal in 2013 would still be possible and could apply retroactively. But the heightened uncertainty would deter some underwater homeowners from selling their homes, and their negative equity would continue to drag on the housing market, Goold warned.

"We have already seen situations where people who are contemplating selling their home -- getting it ready to sell -- are not listing their homes for sale until this issue is resolved," said Goold. "The longer it drags out and the further into 2013, the more chilling effects the failure to extend the relief will have on the housing recovery."

Opponents of the mortgage relief exemption decry its cost -- an estimated $2.7 billion over the next two years -- and describe it as a reward for bad behavior that effectively lets homeowners off easy for buying more house than they could afford.

Douglas Holtz-Eakin of the American Action Forum told The Washington Post that many of the more conservative congressional freshmen have expressed a powerful opposition to the exemption. He predicted an "uphill fight" to get it passed.

But Goold counters that many of those homeowners did nothing wrong but were left stranded with expensive mortgages when the housing market imploded around them.

"I can be current on my mortgage, I could have made every single payment, and I could live in a zip code where values have gone down and be underwater," Goold said. "In that situation, particularly that situation, why would you ever want to put people in the position of having to pay tax on money they've already lost?"

Also on HuffPost:

Close



What Could Fall Off The Fiscal Cliff

of





In his last offer to House Speaker John Boehner (R-Ohio), President Barack Obama lobbied for $16 billion in cuts from the military's health care program, TRICARE. In 2012, the president also proposed hiking fees for military personnel and veterans who receive benefits under the program in an effort to help cut the defense budget. His proposal drew significant fire from Republican lawmakers and veterans' groups.

Both sides agreed to cuts from the military retirement program. Rep. Eric Cantor (R-Va.) claimed during July 2011 talks that lawmakers had reached a tentative deal to slash $11 billion. Under the current system, military personnel receive immediate retirement benefits after serving for 20 years. According to a recent report from the Congressional Budget Office, the appropriation cost per active military service member has increased at a higher rate than either inflation or the total pay package of private-sector employees. Given the budget constraints looming before the Defense Department, the CBO floated the idea of transitioning the military retirement program to a matching-payment model.

Cantor claimed that Republicans and Democrats had agreed to $36 billion in savings over 10 years from civilian retirement programs. The president proposed a marginally more modest figure of $33 billion in his final offer to House Speaker John Boehner. Just this year, Republicans in the House Committee on Oversight and Government Reform also looked to find savings from the Federal Employee Retirement System by requiring employees to pay more of their salary into their pensions, which Democrats opposed as a pay cut that would make civil service less attractive for top talent.
In September 2011, the federal government employed over two million individuals, either through the cabinets or independent agencies. Many Republicans have complained that the federal workforce has ballooned during the Obama administration, and while the raw number of employees has risen by 14.4 percent between Sept. 2007 and Sept. 2011, the percentage of public employees out of the total civilian workforce has remained fairly constant around 1.2 percent since 2001. Much of the raw growth has been concentrated in the Department of Defense, Veteran's Affairs and Homeland Security.

Democrats and Republicans agreed to cut as much as $30 billion from agricultural subsidies; the main opposition fell along geographical lines rather than partisan ones. Hailing from an agriculture-heavy state, Sen. Max Baucus (D-Mont.) threatened to pull out of talks entirely if a deal included that much in subsidy reduction. The president ended up pushing for $33 billion in cuts, but that figure also included reductions in conservation programs. Baucus now tells HuffPost any cuts should be made through the farm bill, not fiscal cliff talks.

Cantor pushed hard for significant cuts to food stamps, formally known as the Supplemental Nutrition Assistance Program. He charged that the federal government could save as much as $20 billion over ten years by eliminating waste and fraud, but the White House countered that the real number was closer to $2 billion. Instead, those cuts would force the program to scale back on the number of enrollees and the level of benefits it could offer.

Obama proposed cutting $4 billion from flood assistance funding in his final offer to Boehner in July 2011. But Hurricane Sandy straining the National Flood Insurance Program; The New York Times reports that thousands of claims are being submitted daily, which could send the overall cost upwards of $7 billion for a program that suffers from a ballooning debt problem. And with climate change promising future flooding disasters along the eastern seaboard, cutting the program looks unwise.

The president offered to cut $110 billion over the next decade from the government's health care spending, excluding Medicare. Among the programs that could lose crucial funding is home health care, where Democrats and Republicans agreed to $50 billion in reductions over ten years. Cantor pushed for closer to $300 billion in spending cuts to health care, but Democrats appeared to stand firm.

The president proposed cutting $10 billion from higher education over the next decade, mostly from Pell grants. Over nine million students relied on federal subsidized loans to afford college during the 2010-2011 school year, and the skyrocketing costs have continued to diminish the purchasing power of the Pell grant program. Obama has actively worked to make college more affordable for lower-income students. Key Republican lawmakers have attempted to cut funding for student loans; most notably, Rep. Paul Ryan (R-Wis.) slashed the maximum award from $5,550 per student per year down to just $3,040.

The original funding levels proposed by Cantor and the GOP leadership would turn the entitlement program for America's poor into little more than a block grant program, Democrats claimed during the 2011 debt ceiling talks. Under such a program, they argued that states would then drop more people from enrollment and scale back on health benefits. In fiscal year 2009, over 62 million Americans -- many of them children -- depended on Medicaid for their health care. But the president did agree to $110 billion in cuts from Medicaid and other health programs.

Republicans pushed for a drastic overhaul to the entitlement program for America's seniors. Ryan infamously proposed turning Medicare into little more than a voucher system in which seniors would receive checks to purchase their own health care on the open market -- a plan that would ultimately force individuals to shoulder more of the burden for their health care costs.
Democrats refused to accept changes similar to those in Ryan's plan. The president, however, was more open to other GOP suggestions on Medicare. In his final offer to Boehner, he agreed cut $250 billion over the next ten years -- in part by increasing premiums for higher-income seniors and by raising the eligibility age from 65 to 67 (although over a longer time frame).

Republicans have again and again decried any attempt to raise taxes, either on the highest earners or on corporations. (A Democracy Corps/Campaign for America's Future survey shows that 70 percent of voters support raising taxes on the wealthiest two percent of Americans.) Instead, Boehner has pushed for a comprehensive tax reform bill that would lower the marginal tax rates while closing loopholes and eliminating deductions in order to raise around $800 billion in additional revenues. For many Democrats, that figure simply isn't enough. White House Press Secretary Jay Carney announced Tuesday that the president was aiming for as much as $1.6 trillion in new revenues, and the president told reporters on Wednesday that it would be practically impossible to raise the amount of revenue he wanted simply from closing loopholes and lowering rates.

Social Security isn't driving the deficit, yet Republicans have pursued drastic changes to the program. Sen. Harry Reid (D-Nev.) has promised that Social Security would be off the table in the on-going negotiations to avoid the fiscal cliff, but Obama did concede to tying the benefits to a recalculated Consumer Price Index that would ultimately provide less money to retirees. Sen. Bernie Sanders claims that, under such a measure, seniors who are currently 65 years-old would see their benefits drop by $560 a month in 10 years and by as much as $1,000 in 20 years. The Moment of Truth project (led by the two former co-chairs of the president's deficit reduction commission, former Sen. Alan Simpson (R-Wyo.) and former White House Chief of Staff Erskine Bowles) claims that the recalculated CPI could save as much as $112 billion from Social Security over the next ten years.

Although Cantor and other GOP House members demanded that any deficit-reduction deal brokered in 2011 be classified as revenue-neutral, they were open to closing particular loopholes in the corporate tax code and limiting itemized deductions for individuals -- given that they were offset by other tax cuts. Out of the $50 billion in savings to be found over the next decade from closing loopholes, Cantor proposed getting $3 billion from eliminating the break for corporate-jet owners and another $20 billion from voiding the subsidies for the oil and gas industries.
On the individual earner side, he proposed eliminating the second-home mortgage deduction for $20 billion, as well as limiting the mortgage deduction for higher-income households to rake in another $20 billion. He also offered to tighten the tax treatment of retirement accounts.
But Democrats wanted to see even greater action taken on itemized deductions. In June 2011, Rep. Chris Van Hollen (D-Md.) proposed raising $130 billion in new revenues by capping itemized deductions at 35 percent for the highest income brackets. The GOP response to his proposal at the time was a resounding "no."

Set to expire on Dec. 31, 2012, the Bush tax cuts represent one of the most controversial elements of the so-called fiscal cliff. They added over $1.8 trillion to the deficit between 2002 and 2009. Yet Republicans argue that an extension is necessary to create jobs and spur economic growth. But a study from the Congressional Research Service found that tax cuts for the wealthiest earners had little economic effect.
The White House is pushing for a renewal only of those tax breaks for the lower- and middle-class Americans in order to save the average middle-class family between $2,000 and $3,500 next year. Letting the cuts expire for those earning over $250,000 a year -- or the wealthiest two percent of Americans -- would haul in $950 billion in savings over the next decade, according to the CBO. Obama stressed how much the country stood to gain from such an approach Wednesday during a press conference.
"If we right away say 98 percent of Americans are not going to see their taxes go up — 97 percent of small businesses are not going to see their taxes go up," he said. "If we get that in place, we're actually removing half of the fiscal cliff."